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Thursday, December 26, 2013

The Federal Reserve: Was it a Mistake?

The Federal Reserve reached its 100th anniversary this year, which can be both a time for thinking about what has happened, or for thinking about what might have been.

If you would like an overview of the substantial shifts and changes in the Federal Reserve over time, a useful starting point is a symposium in the Fall 2013 issue of the Journal of Economic Perspectives. For example, Ben Bernanke writes about the history of the Fed with an emphasis on five "great" episodes: "the Great Experiment of the Federal Reserve’s founding, the Great Depression, the Great Inflation and subsequent disinflation, the Great Moderation, and the recent Great Recession." Gary Gorton and Andrew Metrick look at "The Federal Reserve and Panic Prevention: The Roles of Financial Regulation and Lender of Last Resort."Julio Rotemberg considers the goals and tactics that the Federal Reserve has used over time in seeking to ameliorate swings of the business cycle. Barry Eichengreen looks at when the Fed has acted because of concerns over international consequences, and predicts that the international dimension of monetary policy will play a larger role for the Fed in the future. Full disclosure: As usual, all JEP papers are freely available on-line, courtesy of the American Economic Association. My job as Managing Editor of the JEP has been paying the household bills since 1986.)

But if you are looking for what is in some way an even bigger-picture discussion of the Fed, the November 2013 issue of Cato Unbound tackles the issue: Was the Fed a mistake? the main essay is written by Gerald P. O'Driscoll, and then comments follow from Lawrence White, Scott Sumner, and Jerry Jordan. O'Driscoll summarizes a theme that runs through the essays this way: "The 19th century economic journalist and Economist editor Walter Bagehot thought it would have been better if the Bank of England had never been created. In Lombard Street, Bagehot argued that a decentralized system of many banks of approximately equal size would have been preferable. ... Bagehot’s famous dictum that Bank of England must lend freely at penalty interest rates in times of panic was a second-best solution to a problem caused by centralizing reserves in that institution.
Having said that, Bagehot argued that, once created, it was not possible to abolish central banking."
Similarly, O'Driscoll argues that while certain banking reforms were needed back in 1913, the creation of a central bank was a mistake--albeit a mistake that it may not now be possible to reverse.

What does the case against the Fed look like?

For substantial portions of the Fed's history, its main role has been to help the federal government borrow: obvious examples include during and after World War I, during and after World War II, and during and after the Great Recession. Indeed, O'Driscoll argues that one main reason for the creation of central banks is that they enable high levels of government borrowing, which then impose later economic costs.

At other times in Fed history, its actions have contributed to sometimes quite severe swings in business cycles. For example, misguided Fed policies probably contributed to the large business cycle swings of the 1920s; to the Great Depression of the early 1930s and the steep recession of 1937-38; to the "stagflation" combination of inflation and recession in the 1970s; and to the climate of overborrowing that created fertile soil for the Great Recession. By O'Driscoll's reckoning, the Fed has had about 30 years out of its first century when it wasn't either just a mechanism for high government borrowing or wasn't enacting deeply misguided policies: the 1950s, and the period from the mid-1980s to the mid-2000s.

In short, this indictment runs, it is at a minimum not obvious from the historical record that the Fed has offered more benefits than costs. Of course, a natural response to this charge to say something like: "Well, I just can't imagine not having a central bank. Everyone who's anyone has a central bank." But a lack of imagination in thinking about alternative monetary institutions is not much of a defense of the current central banking institutions.

O'Driscoll argues that a modern banking system does need constraints, so that the banks don't run amok in overborrowing and create financial instability. He suggests a commodity standard, like a gold standard, as such a constraint. My own sense is that a modern central bank--that is, not the Fed as it existed in the 1920s and 1930s--is clearly preferable to a commodity standard. Moreover, in the extraordinarily complex world of modern finance, I don't think a commodity standard would be anywhere close to a sufficient level of financial regulation.

But there is also no reason to expect that the Fed will stand still in its goals and tactics. The history of the Fed over the last 100 years shows lots of change and evolution over time. Back as recently as 1994, for example, the Federal Open Market Committee just took actions to adjust the federal funds interest rate, but did not release any statement explaining why. Of course, the Fed has also shown a high capacity for innovation (for better or worse!) during the Great Recession and since then, by announcing that a policy of near-zero interest rates would be sustained into the future and through its quantitative easing policies of buying Treasury debt and mortgage-backed securities directly. I don't expect the Fed to be abolished. But I wouldn't be surprised if the Fed in a decade or two is operating in substantially new and different ways.